Column: An Economics Masterpiece You Should Be Reading Now

The most valuable new book I’ve read this year is Justin Yifu Lin’s The Quest for Prosperity. George Akerlof, a Nobel laureate in economics and a man not given to reckless overstatement, calls it “a masterpiece.” I’d say that’s right.

Lin is an interesting man. In 1979, as an officer in Taiwan’s army on the fast track to the elite, he defected to the People’s Republic of China by swimming the channel between a Taiwanese island and Xiamen on the mainland. He continued his studies in economics, became a leading scholar, and was an observer and participant in China’s economic miracle. From 2008 until earlier this year, he was the World Bank’s chief economist. Today, he’s back in China, at Peking University.

Lin’s book is intellectually ambitious. He sets out to survey the modern history of economic development and distill a practical formula for growing out of poverty. It’s a serious undertaking: Lin isn’t trying to be another pop economics sensation. But The Quest for Prosperity is lightly written and accessible. It weaves in pertinent stories and observations, drawing especially from his travels with the World Bank. He leavens the economics skillfully.

Essentially, he proposes a middle way between two contending schools: structuralism, which emphasizes barriers to development that government intervention is needed to overcome, and the neoclassical approach, which stresses market forces and frowns on industrial planning. He calls his hybrid “new structuralism,” suggesting a closer affinity with the first. (That branding is a bit misleading, but I can see that the alternative — new neoclassicism — doesn’t roll off the tongue.)

Under the banner of the old structuralism, governments in developing countries made huge mistakes in the 1960s and 1970s. The prevailing approach was import-substitution: Develop capital-intensive industries behind tariff barriers to supply domestic consumers. It worked in the sense that many places industrialized quickly, sometimes on a massive scale. For decades the Soviet Union was perceived both as a great success and as a development model. In India, Africa and Latin America, economic planning led the way.

In every case, this approach ran into the ground. One problem was technological backwardness. Isolation from global markets slowed the accumulation of industrial knowledge, so growth in productivity stalled. Another was fiscal stress. Supporting industrial champions required enormous subsidies, and governments lacked the revenue. Support had to be given in other ways — through overvalued exchange rates (to lower the cost of inputs), price controls, financial repression (forced saving) and administrative direction. These distortions obliterated market signals not just for the favored industries but also across the rest of the economy.

Import-substitution came to be seen as a stunning failure. Especially after the Latin American debt crisis of the early 1980s, the neoclassical consensus and its “structural adjustment” formula took over. Keep government intervention to a minimum, squeeze public spending, free the exchange rate, liberalize finance and foreign trade, and give market forces full rein.

This didn’t work either — at least, not as well as its most enthusiastic advocates had predicted. Growth in many countries stayed slow. Financial crises kept happening. In Africa, countries such as Ghana, once a leader of the import-substitution school, moved abruptly to a market-friendly development strategy. They grew, but still too slowly. Ghana, Lin says, “has not achieved the type of structural transformation that the radical free-market revolution was supposed to bring.”

Structural transformation, of course, is exactly what China has achieved. Elsewhere Lin has acknowledged that China needs further policy reforms and that all is not well. Yet the country’s success of the past several decades is indisputable — and this is no Soviet-style industrialization mirage. Russian factories sold their output to captive markets. Nobody with a choice ever bought a Soviet-made car or television. China’s outward-looking producers are world-class. I’m typing this on a best-of-breed Apple Inc. laptop, manufactured in China.

As I argued in my last column, China is a capitalist country. But how did it get that way?

Lin’s answer draws on both development paradigms. He sees a vital role for government in overcoming barriers to development. But interventions, he argues, must respect compelling market realities. Of these, the most important is international comparative advantage. Poor countries have lots of cheap labor. For them, capital-intensive heavy industry isn’t the way to go.

For today’s developing countries, Lin says, the global economy is the indispensable setting, and looking outward is the sine qua non of rapid development. On the input side, that’s because of the opportunity it affords for technologically driven catch-up growth. On the output side, it’s because the world is a market for exports. On this view, “export pessimism,” the idea that poor countries couldn’t prosper through international trade, was one of the biggest mistakes of the import-substitution school. Globalization is the poor’s best friend.

Governments have to identify industries that are trading internationally and doing well elsewhere — not those based in the most advanced economies (too big a leap) but in countries with incomes roughly double their own. If those industries are getting started at home, help them upgrade their technology. If they aren’t, draw in foreign investors. If infrastructure is poor and doing business is difficult, create special economic zones where those problems can be fixed. Recognize that pioneer companies are taking on larger risks and compensate them with temporary tax incentives, co-financing of investments or preferential access to foreign exchange.

And don’t expect to shut down nonviable producers all at once; that has to be done gradually.

So yes, this is “industrial policy” and “picking winners” — ideas disdained by your typical pro-market type. And I’d say the record justifies a good deal of such skepticism. The book’s main weakness is that it understates the political difficulty of delivering support of the kind it advocates: intelligent, measured, time-limited and disciplined in crucial ways by market imperatives.

This isn’t just an issue in democracies, by the way. As China itself proves, interests gather around patterns of explicit and implicit subsidy, however well-judged at the outset, and the flexibility demanded by Lin’s new structuralism gets ever harder to maintain.

Still, it’s hard to quarrel with the results to date, in China most of all, but also in Taiwan, South Korea, Singapore and other rapidly industrializing economies that adopted similar strategies. If you’re interested in development, you have to read Lin’s book.